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Unformatted text preview: FINC 202 Lecture 17
Managing Current Assets: The Cash Conversion Cycle
1 Topics associated with Managing Topics Current Assets and Current Liabilities Current Current Asset Management
• • • • • • • • • Funding of Current Assets The Cash Conversion Cycle Cash Management Managing Inventory Managing Accounts Receivable Alternative Current Asset Management Policies Brief look at Marketable Securities Alternative Funding Policies Managing Accounts Payable Brief look at Shortterm Debt Notes Payable 2 Cash Conversion Cycle Definitions Liquidity = ability to convert assets into cash Working capital = _____________________ Net working capital
• • • WC = CA NWC = CA CL NOWC = CA – L* L* = spontaneous CL • at short notice • to pay debts • For the CCC we are effectively using NOWC as interest bearing shortterm debt is excluded i.e., Notes Payable are excluded 3 Working capital and liquidity Two key WC measures of liquidity:
• Current ratio • Quick ratio WC ratios incomplete measure of liquidity:
• Firm with low CR may still be able to pay debts • Firm with high CR may not be able to pay debts ⇒ WC ratios _____________________________
_________________________________________ 4 2. Cash Conversion Cycle
Firm is a cashflow system:
process material & pay wages store finished goods sell finished goods on credit _____________ __________________ collect debtors
5 buy materials on credit Cash conversion cycle = length of time • between cash disbursed for raw material labour • and collection of cash from sales Inventory CCC = Conversion Period + Average Collection Period Payables Deferral Period
6 ICP = time taken to convert raw materials into finished goods and then to sell these goods • Note that ICP (for the firm’s internal planning & control) needs to be based on COGS rather than sales Inventory ICP = Average Cost Of Goods Sold Note that if we know the ITO ratio, then: 360 ICP = Inventory Turnover
7 ______________________________________ Problem 1: D’Leon’s Inventory Conversion Period
Inventory ICP = COGS 360 = 8 . ACP = time taken to convert accounts receivable into cash Receivables ACP = Average daily credit sales
Credit Sales / 360 = DSO = RCP “Receivables Collection Period” • Note, the textbook uses a 365day year. • We will standardise on a 360day year. • But please note that both choices are arbitrary simplifications 9 Problem 2: D’Leon’s Average Collection Period DSO =
Receivables Credit Sales 360 Assume all sales are credit sales = . 10 10 Problem 3: D’Leon’s Average Collection Period CREDIT SALES ONLY = Receivables DSO Credit Sales 360 Assume 80% of sales are credit sales = 11 11 . Payables Deferral Period The length of time taken to pay off Accounts Payable and Accrued Wages & Taxes, on average.
• Accounts Payable + Accrued Wages & Taxes = L* Textbook calls L* by the name, “Payables” L* PDP = COGS 360 12 12 Problem 4: D’Leon’s Payables Deferral Period
PDP = L* Cost Of Goods Sold 360 = . 13 13 The Cash Conversion Cycle Inventory Conversion Period Average Collection Period Payables Deferral Period Days Receive Materials Pay cash for Purchased Materials Sell Finished Goods on credit Collect cash 14 14 for Accounts Receivable Example/Problem 1: Hop Ltd Balance Sheet Cash 200,000 Acc/Pay 400,000 A/R 700,000 Accruals 100,000 Inventory 540,000 Notes Payable 50,000 Total CA 1,440,000 Total CL 550,000 Longterm Debt 450,000 Fixed Assets 800,000 Total Debt 1,000,000 Equity 1,240,000 Total Assets 2,240,000 Tot. Liabs & E 2,240,000
Sales are $4.5m, COGS are $3.6m, and NPAT margin (M) is 5% 15 15 Compute the Hop Ltd’s: a) b) c) d) e) f) Inventory turnover (COGS/inventories) Inventory conversion period Day’s sales outstanding Payables Deferral Period Cash conversion cycle Return on assets 16 16 A 360day year is used in this solution
Inventory Solution 1 (a) Inventory Turnover = COGS
= 17 17 . (b)
ICP = Inventory = Average Daily COGS . 18 18 (c) (c)
DSO = Receivables = Daily Credit Sales 19 19 (d) L* PDP = = Average Daily COGS . 20 20 (e) (e)
CCC = ICP + DSO + PDP = . 21 21 (e) NPAT ROA = Total Assets Sales × M = Total Assets = . 22 22 Length of CCC affected by: Speed of production process inventory policy
• How much storage of Raw Materials Work in Process Finished goods • Loose? • Tight? Credit terms offered to customers Collection ________________________ Payment policy regarding firm’s suppliers 23 23 CCC varies between firms: 1. Manufacturer
High ICP ⇒ high CCC 2. Service firm
_________________________________ 3. Supermarket
Zero DSO, PDP > ICP ⇒ negative CCC
24 24 Implications of the length of CCC The longer the CCC • the more Current Assets there will be on the Balance Sheet That need to be funded • The ___________________________________________ • A source of funds • Rather than a use of funds The shorter the CCC A negative CCC makes Working Capital A negative CCC provides funding for other uses: _________________________________________ Investment in plant (ie, Fixed Assets)
25 25 • Examples: Amazon.Com; Dell Computers Firm should aim to minimise CCC: reduce ICP • process and sell goods faster reduce DSO raise PDP • collect debtors faster • __________________________________ • Reduce speed of payments • without ____________________________ Not too slow! 26 26 Example/Problem 2: Hop Ltd (Again!)
The CFO claims that she can reduce ICP by 14 days and DSO by 20 days without reducing the NPAT margin. (a) What is the new level of inventory? (b) What is the new level of accounts receivable ? (c) What is the new CCC? (d) If all “savings” are used to reduce what will be Hop Ltd’s new ROA? debt 27 27 Solution 2 (a) Inventory ICP = Av. Daily COGS ⇒ Inventory = ICP × Av. Daily COGS If ICP = 54 −14 Inventory = and 3, 600, 000 = 10, 000 360 28 28 . (b) (b) Av. Receivables = DSO × Av. Daily Cr. Sales where DSO = 56 − 20 Therefore, Av. Receivables = 29 29 (c) (c) CCC = ICP + DSO − PDP = . 30 30 (d) Original New 450,000 400,000 850,000 Receivables 700,000 Inventory 540,000 1,240,000 Therefore Reduction = 31 31 Reduction in CA = = New Total Assets = = ROA = = .
32 32 ...
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This note was uploaded on 12/23/2009 for the course BCOM FINC 202 taught by Professor Warwickanderson during the Spring '09 term at Canterbury.
- Spring '09